Top Stories | Tue, 17 Dec 2024 03:02 PM

Top 20 Capital Budgeting Interview Questions and Answers for Professionals

Posted by : SHALINI SHARMA

Capital Decision-Making

It is the process of evaluating and deciding long-term investment opportunities is capital budgeting in organizations. It includes analyzing the possible projects or investments such as acquiring new machinery, launching new products or facilities to determine whether an investment can be outlasted and considered profitable and aligned according to the strategic goals of the organization. Capital budgeting is fundamentally concerned about the proper allocation of financial resources towards projects which tend to bear fruit vertically and adds to wealth growth in the long run.

Important terms in Capital Budgeting: 

Net Present Value (NPV): Difference between present value of cash inflows and outflows at the end of the time period.

Internal Rate of Return (IRR): This is the discount rate under which NPV related to investment becomes equal to 0. An investment is said to be good whose IRR is more than cost of capital.

Payback Period: The period within which the investment will again receive its initial cost through its cash inflows. Shorter paybacks are better this method does not consider time value of money.

Discount Rate: This is the rate at which future cash flows are discounted to convert them into present value: It is based on cost of borrowing or required rate of return.

Cash Flows: Cash inflows and outflows associated with any project. Only the cash flows directly associated with a project that are relevant, incremental cash flows, are included in relevant cash flows.

Profitability Index (PI): A ratio of the present value of future cash inflows to the initial investment. A PI greater than 1 indicates profitability.

Formula:

PI = PV of Future Cash Flows/Initial Investment

1.What is Capital Budgeting?

Capital budgeting again is the process of evaluating long-term investment projects. It estimates what the cash inflows and outflows would be in order to understand whether or not the company would find that project an addition to the value of the company. It helps select investments that further one's business goals.

2.Why is Capital Budgeting important?

 Capital budgeting leads to the effective utilization of the company resources in the sense of adopting only those projects which give the maximum profitability. It is helpful in risk management, maximization of profits, and supports long-term growth. It is critical with respect to strategic decision making.

3.What are the key techniques used in Capital Budgeting?

 Some of the significant techniques include NPV, IRR, Payback Period, and Profitability Index. These methods take account of the expected profit and risk involved in possible investments. Thus, they undertake the decisions that would favor project selection.

4.How does Net Present Value (NPV) work?

In other words, NPV would be the present value of future cash flows, less the initial investment. Thus, a positive NPV means that the project would add value to the firm. It is a relevant method because it considers the time value of money.

5.What is the Internal Rate of Return (IRR)?

 IRR refers to the discount rate at which NPV amounts to zero cash flows. It represents the value of an investment in terms of recouping losses. So those projects would be accepted if IRR is greater than the cost of capital.

6.How do you calculate Payback Period?

 Payback is the amount of time it takes to recover the originally invested amount from cash inflows generated by the project. An equation divides the initial investment by expected annual cash inflows. A shorter payback period is more the desirable option.

7.What are the advantages of using NPV over IRR?

Through NPV, real dollar amounts are specified as the contribution of a project to a firm's wealth. Unlike IRR, it does not assume reinvestment at the rate of return of the project; hence, it is realistic for decision making.

8.What is the difference between IRR and NPV?

By contrast, NPV gives an absolute measure of the expected return, while IRR refers the expected return to a percentage. NPV is more appropriate when comparable projects are not the same size, while IRR is useful for determining the rate of return of a project.

9.What is the Profitability Index (PI)?

The profitability index is the ratio of the present value of future cash inflows to the initial investment; a pi value above one indicates the project is profitable, and it is suited for cases where there is a rationing of resources.

10.How is the Discounted Payback Period different from the Payback Period?

Unlike a normal payback period, the discounted payback period considers the time value of money; that is, future cash flows are discounted to obtain the present value of cash inflows. This makes the payback period more reflective of the time it would take to recover the investment.

11.What are sunk costs, and why should they be ignored in Capital Budgeting?

Sunk costs refer to fixed expenses that have already been incurred and cannot be recovered. They must be ignored while making capital budgeting decisions because they are irrelevant for future investment decisions. Only future cash flows need consideration.

12.How do taxes affect capital budgeting?

The project loses net cash inflows due to reduction in after-tax return generated from a project. Depreciation, however, provides a tax shield, by lowering taxable income and improving cash flows from the project and should be considered in capital budgeting.

13.What is sensitivity analysis in capital budgeting?

Sensitivity analysis assesses the impact of changing key variables, such as sales or costs, on the NPV or IRR of the project. This helps analyze the robustness of the project in different scenarios and what factors are most critical.

14.What is scenario analysis?

Scenario analysis is evaluating alternative possible outcomes by changing a few variables simultaneously, like the best-case, worst-case, and most likely case scenarios. It assists in assessing the overall risk of the project.

15.What is the role of cash flow forecasting in capital budgeting?

Cash flow forecasting predicts the inflows and outflows that would occur in the future of a project. It is essential in calculating metrics like NPV and IRR so that the project can be financially viable and aligned with the objectives of the company.

16.What is a mutually exclusive project?

Mutually exclusive projects are projects wherein one selection prohibits the other selection. In such cases, the project with the highest NPV or IRR must be selected because only one can be pursued.

17.What is the difference between independent and mutually exclusive projects?

Independent projects can be pursued simultaneously without interfering with one another, while mutually exclusive projects are alternatives in which choosing one eliminates the other. The best choice is made based on financial metrics.

18.What is capital rationing?

Capital rationing occurs when a company has limited resources and must ration investments. In such cases, only the most profitable projects, as determined by metrics like NPV or IRR, are selected for funding.

19.How do your account for risk in capital budgeting?

Risk can be addressed with sensitivity analysis, scenario analysis, or even a risk-adjusted discount rate. These methods would help calculate the potential influence of uncertainty variables on project financial feasibility.

20.What factors should be considered when selecting projects for capital budgeting?

Key factors include project NPV, IRR, the level of risk, alignment with strategic goals, and resources. Other elements that one should consider before finalizing include market conditions and regulatory environment.